Easing the Loan Payback Pain

June 07, 2005

Borrowing money to go to school doesn't have to be a life sentence. Seth O'Donnell, a first-year student at New York Medical College in Valhalla, N.Y., recently paid a visit to his school's financial-aid office to consolidate his federal student loans before July 1, when rates are slated to rise by 1.93 percentage points, to 4.7 percent for students still in school. At 23, O'Donnell, like many of his classmates, is already burdened by hefty debts -- $30,000 from pre-med studies at the University of Notre Dame combined with about $40,000 from his first year of medical school. Consolidating, or locking in low rates now, will help O'Donnell save money down the road.

About three-quarters of all college students borrow money either from the government or private lenders to invest in their education, says Cindy Bailey, executive director of Education Finance Services for the College Board. Along with a diploma, the average college graduate leaves school owing $20,000, according to the U.S. Public Interest Research Group, a watchdog organization based in Washington, D.C. Sallie Mae, the largest private lender and consolidator, loaned over $18 billion in 2004. In 2006, the U.S. government expects to hand over $62 billion in loans.

If more education is in your future, then some of that outstanding loan money is bound to be yours. Here are some tips on how to be a smart borrower:

Lock in rates. Take your cues from O'Donnell and consolidate now. The federal interest rates that expire at the end of June are the lowest since the Higher Education Act, the legislation that Congress uses to manage student loan interest rates, took effect in 1965. "No one can forecast interest rates, but it looks like a pretty sure bet [that rates will start to rise]," says Jamie Wolfe, CFO of Northstar Education Finance, a nonprofit lender based in St. Paul, Minn., that lends mostly to medical and other graduate students.

Borrowers beware. Know the downside of consolidation before you jump on board. Current students wishing to consolidate their federal loans forfeit their usual six-month grace period and, therefore, enter the repayment phase earlier. Consolidation before the July 1 deadline only helps those with federal loans -- private lenders are free to change rates at anytime.

Also in several instances, federally funded Perkins loans, which come at a fixed rate of 5%, should be excluded. For example, if you have Perkins and Stafford loans, which come at variable rates, then it's often to your advantage to keep the interest rates of each separate. Consolidated together, the higher rate of Perkins makes the weighted average higher, though the exact increase depends on the ratio of Stafford to Perkins being consolidated.

In addition, the holder of a Perkins loan might be eligible for special benefits, such as loan forgiveness, and that option will be forfeited if you lock in one rate. Consolidated Perkins loans also forfeit their nine-month grace period.

Find the right payment plan. Eventually, you'll have to pay back all of this borrowed money. You'll find several plans available, aside from consolidation, which carries its own payment plan. For borrowers having trouble making payments, the income-sensitive repayment plan, which would allow you to tie your monthly payments to your income, is a good option, says Erin Korsvall, a Sallie Mae spokesperson. During times of financial hardship, it prevents borrowers from having to default on their loans while continuing to make at least a bit of positive headway.

There's also an interest-only option, sometimes called a graduated repayment plan, which would allow you to pay interest only for two or four years.

Save now so you can pay later. When Tony Sozzo, the financial-aid director at New York Medical College, helps his students consolidate loans, he often advises that they choose a repayment plan that can last up to 20 years and comes with a graduated rate. A lower initial minimum monthly payment during residency and fellowships helps new doctors get through the leaner times before they reach their full earning power.

Sozzo adds that this tactic works equally well for all borrowers. "It helps them get through the startup part of their careers, allowing them the flexibility to get on their feet," he says.

Research what you might have coming to you. Different lenders offer different benefits. On Stafford loans, for example, Sallie Mae borrowers get cash back or a loan credit based on 3.3% of their original Federal Stafford Loan amount after making 33 initial scheduled payments on time. Though great in theory, some financial-aid officers lament the small number of students who really benefit. Only 7% of students ever take advantage of these offers because hardly anyone can meet those high expectations, says Sozzo.

Consider nonprofit and lesser-known lenders. A 3% fee is added to the principal of many Stafford loans. Unlike many large private lenders, nonprofits like Northstar don't include that additional charge. The average medical student can save almost $5,000 just by borrowing from Northstar. "That's why we can be a small no-name company out of St. Paul and still compete head-to-head with the Sallie Maes and Citibanks of the world," says Wolfe.

Live within your means -- and ditch those credit cards. To get out of debt, it's important to live like a student, not the professional you'll be when you graduate, says Wolfe. Frugality pays off in the long run.

And everyone agrees that it's best to avoid credit-card debt. Because borrowers rarely have enough money to pay for both college loans and credit cards, they end up having to choose between the two. School loans are kinder, with an interest rate of 3% to 8%, whereas credit cards can bust your bank account. Brian O'Connell, author of Free Yourself from Student Loan Debt (Dearborn Press, 2004), warns students to avoid bankruptcy at all costs because it ruins their credit rating, which is the number that lenders use to determine their ability to pay them back.

Get into a payment routine, and carry a reminder. Pay in a timely fashion, and don't be afraid to exceed the monthly minimum. Fifty extra dollars per month for a year saves about $1,300 dollars on your loan payment principal over the first nine years of your loan. Also, carry a reminder of your responsibility, like a loan document, in your wallet. It could come in handy when you're thinking of pulling out your credit card to pay for that $1,200 HDTV. "It paints a picture of what's important," says O'Connell.

Maybe the future Dr. O'Donnell, who wisely consolidated his federal loans, will be able to afford that big-screen TV down the road. Now, if only he could consolidate his residency. By Jeffrey Gangemi in New York